Understanding types of investment risks

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An important part of your investment journey is to understand risks and match them with your risk tolerance or profile.

Common types of risks in investing include market risk, volatility, currency risk, liquidity risk, inflation risk, and interest rate risk.

Deposits and government bonds are generally regarded as low-risk assets. However, there are some nuances. For example, investment grade bonds are usually less risky than speculative grade bonds.

Within equities, there will also be different levels of risk for different stocks and categories of stocks. Emerging market stocks, for instance, are generally riskier than developed market (such as US) equities.

All investments carry some form of risk. An important part of your investment journey is to understand risks and match them with your risk tolerance or profile.

Banks and other financial institutions typically gauge your risk appetite through questionnaires before providing advice or recommending you an investment product.

Here are some common types of risks you may encounter when investing:

Market Risk

Most investments have market prices against which they are benchmarked. Market risk refers to the market price of the investment compared to the investment cost.

When the market price falls below your investment cost, you suffer a “mark to market” loss. And if you sell below your investment cost, you will “realise” that loss (that is, turn a “paper loss” into an actual loss).

Volatility

Even if you hold on to the investment—that is, don’t “realise” an actual loss—you will still take on “paper loss”. So, volatility, or price movements in either direction, is another risk that investors have to consider. Can you stomach big price movements in either direction?

Foreign Exchange or Currency Risk

This arises when you invest in foreign assets. Firstly, you are exposed to currency risks if your investments are denominated in a foreign currency. Even if your assets increase in price in that foreign currency, big declines in that foreign currency relative to your home/base currency can result in a loss measured in your home/base currency.

Secondly, if your investment is denominated in your home currency, but the underlying assets are held in foreign currencies, you are still exposed to currency risk. An example is a Singapore Dollar-denominated unit trust that invests in global stocks or bonds.

Liquidity Risk

This arises when there are few buyers and sellers for a particular asset. An example is in “over-the-counter” (OTC) bonds, where there may be instances of very few buyers when you need to sell. In that situation, you may be faced with a big “bid-ask spread”. This means you have to sell your asset at a price (called the “bid” price) that is significantly below your “asking” price.

In times of crises, the situation may worsen. For example, in the case of funds, redemptions may be suspended. In such instances, there is no liquidity and you will not be able to sell your investment.

Inflation Risk

Inflation is an important consideration—if you do not invest and even if you invest. In the latter case, it is because if your investment return is lower than the inflation rate, the purchasing power of your money may decline over time.

Issuer Risk

Two common situations of “issuer risk” relate to bonds and structured products. Bonds are debt instruments issued by companies, with a promise of regular interest payments (“coupons”) and the repayment of principal on maturity. These payments depend on the issuer’s financial ability to keep its promises.

In the case of structured products, payments or repayments also depend on the issuer’s financial ability to keep its contractual obligations.

Interest Rate Risk

Almost all investments are affected by interest rates. Generally, higher interest rates are associated with lower market valuations for investments—which mean lower returns. Some of the most interest rate-sensitive investments are bonds and real estate investment trusts (REITs).

Deposits and government bonds are generally regarded as assets with the lowest risk. But not all deposits and government bonds are equal in terms of risk. Their risks are linked to the creditworthiness of the bank holding the savings and the country issuing the bonds.

Agencies such as Standard and Poor’s (S&P) and Fitch Ratings assign ratings on bonds, countries, and other investments to gauge the general ability of a country or company to repay its debt. The higher a country’s or company’s ability to do so, the more creditworthy it is—which also means the less likely it will “default” on its payments.

Hence, a bond issued by an AAA-rated (on the S&P ratings system) country would be lower risk than one issued by a BBB-rated country. As a reference, the US government’s credit rating is AA+. The Singapore government’s credit rating is AAA.

However, lower on the scale, Turkey’s long-term foreign currency credit rating is B+, and its local currency credit rating is BB-. Hence, a Singapore Savings Bond (issued by the government) is less risky than a government bond from an emerging market such as Turkey.

Similarly, while corporate bonds are generally regarded as lower risk than equities, the risk of specific bonds can vary greatly from investment grade bonds to speculative grade bonds.

Again, it goes back to the creditworthiness of the bond issuer. A study (1986-2017) by S&P Global Research suggests the following probabilities of a default over a five-year period:

For a top investment grade (AAA) bond: 0.35%

When you get to the low end of the investment grade spectrum (BBB-): 2.84%

When you hit the low end of the speculative grade range (CCC-rated): 46.22%


Within equities, there are also different risk levels for different stocks and categories of stocks. For example, emerging markets (using the MSCI Emerging Market Index as a proxy) have a much higher long-term standard deviation of 22% than US equities (using the S&P 500 Index as a proxy), which have a long-term standard deviation of 15%. Standard deviation is a measure of volatility and investment risk.

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